Completing theAccounting CycleCompleting theAccounting Cycle

C H A P T E R 4

Learning Objective 1

Describe how accrual accounting allows for timely reporting and a better measure of a company's economic performance.

Why Use Accrual Accounting?

Accrual-basis accounting

better measures a

firm’s performance

that does cash flow data.

Business requires

periodic, timely reporting.

Define the Time Period Concept.

Time Period Concept—the life of a business is divided into distinct and relatively short time periods so the accounting information can be timely, generally 12 months or less.

Financial ReportsMost companies report to

stockholders at fiscal year-end.

Other reports are issued more frequently, perhaps monthly or quarterly.

This frequency of reports forces accountants to use data based on judgments and estimates.

ABC Inc.Annual Report

Define Accrual Accounting

A system of accounting in which revenues and expenses are recorded as they are earned and incurred, not necessarily when cash is received or paid.

Provides a more accurate picture of a company’s profitability.

Statement users can make more informed judgments concerning the company’s earnings potential.

Revenue Recognition

Revenues are recorded when two main criteria are met: What are they?

Cash has either been collected or collection is reasonably assured.

The earning process is substantially complete

Define The Matching Principle

All costs and expenses incurred in generating revenues must be recognized in the same reporting period as the related revenues.

This process of matching expenses with recognized revenues determines the amount of net income reported on the income statement.

costs and expensescosts and expenses

related revenuesrelated revenues

Define Cash-Basis Accounting

Revenues and expenses are recognized only when cash is received or payments are made.

Mainly used by small businesses.

Not an accurate picture of true profitability.

Example: Accrual- vs. Cash-Basis Accounting

Crown ConsultingReported Income for 2002

During 2002, Crown Consulting billed its client for $48,000. On December 31, 2002, it had received $41,000, with the remaining $7,000 to be received in 2003. Total expenses during 2002 were $31,000 with $3,000 of these costs not yet paid at December 31. Determine net income under both methods.

Cash-Basis Accounting

Cash receipts $41,000Cash disbursement 28,000 Income $13,000

Accrual-Basis Accounting

Revenues earned $48,000 Expenses incurred 31,000 Income $17,000

Learning Objective 2

Explain the need for adjusting entries and make adjusting entries for unrecorded receivables, unrecorded liabilities, prepaid expenses, and unearned revenues.

What Are the Steps in the Accounting Cycle?

1. Analyze transactions and business documents.

2. Journalize transactions.

3. Post journal entries to ledger accounts.

4. Determine account balances and prepare a trial balance.

5. Journalize and post adjusting entries.

6. Prepare financial statements.

7. Journalize and post closing entries.

8. Balance the accounts and prepare a post-closing trial balance.

Why DO Adjusting Entries?

Adjusting entries are required at the end of each accounting

period for accrual-basis accounting, prior to preparing

the financial statements.

To bring balance sheet accounts current.

To reflect proper amounts of revenues and expenses on the Income Statement.

Adjusting Entries Tips

Each adjusting entry always involves at least one income statement account and one balance sheet account.

Each adjusting entry always involves at least one income statement account and one balance sheet account.

Adjusting entries never involve cash.

Define Each of These Common Adjusting Entries

Unrecorded Receivables

Unrecorded Liabilities

Prepaid Expenses

Unearned Revenues

Revenues earned but not yet recorded by period’s end.

Expenses incurred but not yet recorded by period’s end.

Payments made in advance for items normally charged to expense.

Amounts received before the actual earning of revenues.

Unrecorded Receivables &

Liabilities will have no original entries.

Always debit a

Receivable & credit a Revenue

for unrecorde

d receivable

s

Always debit an

Expense & credit a

Liability for unrecorded liabilities

What Is the 3-Step Process forAdjusting Entries?

1. Identify the original entries that were made (original entries are only made for unearned revenues and prepaid expenses).

2. Determine what the correct balances should be at this point in time.

3. Make the adjustments needed to correct the balances.

Bullseye Management earns a rent revenue of $500 in 2002 but will not receive the payment until January 10, 2003. An adjustment will be needed. What is the adjusting entry?

Example: Unrecorded Receivables

Original entry none none

Correct balances 500 500

Rent Receivable Rent Revenue

Adjusting entry: 12/31/02 Rent Receivable 500 Rent Revenue 500

Original entry none none

Correct balances 1,000 1,000

Property TaxExpense

Property Tax Payable

Example: Unrecorded Liabilities

Adjusting entry: 12/31/02Property Tax Expense 1,000 Property Tax Payable 1,000

MoneyTree Inc. is assessed property taxes of $1,000 for 2002, but will not make this payment until January 5, 2003. An adjustment will be needed. What is the adjusting entry?

Example: Prepaid Expenses

Adjusting entry: 12/31/02 Rent Expense 1,800 Prepaid Rent

1,800

Rent ExpensePrepaid Rent

Original entry 3,600 3,600

Adjusting entry 1,800 1,800

Correct balances 1,800 1,800

Cash

On July 1, 2002, I Think I Can Inc. pays $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. What is the adjusting entry?

Example: Unearned Revenues

Adjusting entry: 12/31/02 Unearned Rent 1,800 Rent Revenue 1,800

On July 1, 2002, Clean As A Whistle Co. received $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. What is the adjusting entry?

Unearned RentRent Revenue Cash

Original entry 3,600 3,600

Adjusting entry 1,800 1,800

Correct balances 1,800 1,800

Learning Objective 3

Explain the preparation of the financial statements, the explanatory notes, and the audit report.

Review The Steps in the Accounting Cycle

1. Analyze transactions and business documents.

2. Journalize transactions.

3. Post journal entries to ledger accounts.

4. Determine account balances and prepare a trial balance.

5. Journalize and post adjusting entries.

6. Prepare financial statements.

7. Journalize and post closing entries.

8. Balance the accounts and prepare a post-closing trial balance.

PreparingFinancial Statements

Prepared directly from the data in the adjusted ledger accounts.

Explanatory notes clarify the methods and assumptions.

The auditor reviews the statements with GAAP.

What Are The Notes and Why Have Them?

List assumptions and methods used in preparing financial statements.

Give more detail about specific items.

Serve to augment the summarized, numerical information.

Tell Me About The Audit

Audits statements to check conformity with GAAP.

Reviews adjustments.

Samples selected accounts.

Reviews accounting systems.

Attaches report and distributes it with financial statements.

Learning Objective 4

Perform a systematic analysis of financial statements.

What Does The DuPont Framework Do?

Summarizes the financial health of a company.

Systematic approach for breaking down ROE into three ratios:

1. Profit margin (measure of profitability)

2. Asset turnover (measure of efficiency)

3. Assets-to-equity ratio (measure of leverage)

Summarizes the financial health of a company.

Systematic approach for breaking down ROE into three ratios:

1. Profit margin (measure of profitability)

2. Asset turnover (measure of efficiency)

3. Assets-to-equity ratio (measure of leverage)

What Are the Components of ROE?

Return on Equity = Net Income

Equity

Profitability x Efficiency x Leverage

Asset Assets-to- Turnover Equity Ratio

x xProfit Margin

Net Income x Revenue x Assets

Revenue Assets Equity

Uncommon CompanyCommon-Size Income Statement

For the Year Ended 12/31/02

Revenues. . . . . . . . . . . . . . . . $10,000100%Cost of sales. . . . . . . . . . . . 5,000 50 Selling & admin. exp. . . . . . 1,500 15

Income before taxes. . . . . . . . $ 3,500 35%

Income tax expense. . . . . . . . 1,000 10

Net income. . . . . . . . . . . . . . . $ 2,500 25%

Common-Size Financial StatementsDivide all financial statement numbers for a given

year by the total revenues for the year.All amounts are then shown as a percentage of

revenues for that year.Helps to pinpoint problem areas.

Learning Objective 5

Complete the closing process in the accounting cycle.

Describe The Closing Process

Real AccountsReport the cumulative

increases and decreases in balance sheet accounts from the date of organization.

Permanent; they are not closed to a zero balance at the period’s end.

Balances are carried forward to next period.

Nominal AccountsTemporary accounts

(revenues, expenses, and dividends) closed to a zero balance at the end of each period.

At period’s end, adjustments are made, the income statement is prepared, and balances are then closed to Retained Earnings.

Closing Entries Identify Nominal and Real Accounts

Dec. 31 Sales Revenue. . . . . . . . . . . 1,500

Rent Revenue. . . . . . . . . . . . 100

Cost of Goods Sold . . . . . 1,100

Salaries Expense. . . . . . . 200

Other Expenses . . . . . . . . 150

Retained Earnings . . . . . . 150

real (permanent) account

nominal or temporaryaccounts

Step 1. Close all revenue accounts by debiting them.

Sales Revenue. . . . . . . . . 15,000Retained Earnings . . . . 15,000

Closing Entries Describe Which Accounts Are Used For Each Entry

Step 2. Close all expense accounts by crediting them.

Retained Earnings. . . . . . . 13,600Cost of Goods Sold. . . . 12,800Insurance Expense. . . . 500Supplies Expense. . . . . 300

Dividendsa nominal accountnot expensesdistributions to stockholders of part

of the corporation’s earningsreduce Retained Earningsare declared and paid

To close, credit Dividends and debit Retained Earnings.

Closing the Dividends AccountDiscuss the Dividends Account

Declaration of Dividends:Dividends. . . . . . . . . . . . . . . 200

Dividends Payable . . . . . . 200

Payment of Dividends:Dividends Payable . . . . . . . 200

Cash . . . . . . . . . . . . . . . . 200

Closing Entry for Dividends:Retained Earnings . . . . . . . 200

Dividends . . . . . . . . . . . . 200

Make All Three Dividends Entries for $200

The Closing Process

Since the revenues account is a nominal account, it is closed at the end of the period to Retained Earnings.

Retained Earnings Revenues

Bal. xxx Beg. Bal. xxxxxx

Revenues

Expenses

Bal. xxx xxx

Expenses

The expenses account is also a nominal account and is debited to Retained Earnings to close it.

Dividends

Bal. xxx xxx

Dividends

The dividends account, which is also nominal, is credited to close out the balance.

End. Bal. xxx

Net income for the period is determined by these two entries.

Retained Earnings is a real account and always carries a balance.

Optimal last step.

Information taken from the General Ledger after all closing entries are posted.

Lists all real account balances at the end of the closing process.

Assures that total debits equal total credits prior to the beginning of the new accounting period.

Only real accounts will have a balance at this time.

Optimal last step.

Information taken from the General Ledger after all closing entries are posted.

Lists all real account balances at the end of the closing process.

Assures that total debits equal total credits prior to the beginning of the new accounting period.

Only real accounts will have a balance at this time.

Post-Closing Trial Balance

Three Monkeys Inc. Post-Closing Trial Balance December 31, 2002

Debits CreditsCash $ 8,200Accounts Receivable 4,000Inventory 3,000Supplies 1,000Accounts Payable $ 5,000Capital Stock 10,000Retained Earnings ______ 1,200 Totals $16,200 $16,200

Example: Post-ClosingTrial Balance

Learning Objective 6

Understand how all the steps in the accounting cycle fit together.

Summary of theAccounting Cycle

Financial statements:Result from the accounting cycle.Provide useful information to investors, creditors, and other users.Are included in the annual reports provided to stockholders.Can be analyzed and compared to statements of similar firms to detect strengths and weaknesses.

Learning Objective 7Expanded Material

Make adjusting entries for prepaid expenses and unearned revenues when the original cash amounts are recorded as expenses and revenues.

Adjusting entry: 12/31/02 Prepaid Rent 1,800 Rent Expense 1,800

Example: Prepaid Expenses

Rent ExpensePrepaid Rent Cash

Original entry 3,600 3,600

Adjusting entry 1,800 1,800

Correct balances 1,800 1,800

On July 1, 2002, Time Flies Company pays $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. What is the adjusting entry using the expense approach?

Adjusting entry: 12/31/02 Rent Revenue 1,800 Unearned Rent 1,800

Example: Prepaid Expenses

Unearned RentRent Revenue Cash

Original entry 3,600 3,600

Adjusting entry 1,800 1,800

Correct balances 1,800 1,800

On July 1, 2002, Pot Of Gold Inc. pays the Rainbow Company $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. Use the revenue approach.

Appendix A: Using a Work Sheet

What Is a Work Sheet?

A columnar schedule used to summarize accounting data.

For internal use only.

Helpful for organizing large quantities of data.

Most use computer spreadsheets.

How Does It Work?

First list the trial balance.

Then add any adjusting entries.

Extend the combined amounts to the appropriate statement columns.

Add a balancing figure if debits do not equal credits.

Sales JournalRecord credit sales at their gross amounts,

noting discounts at the time of collection (in

the Cash Receipt Journal).

Appendix B: Special Journals

Purchases JournalRecord credit

purchases. At period’s end, post total to both Accounts Payable and

Purchases.

Cash Disbursements JournalRecord all cash paid out for supplies, merchandise, salaries, and other items.

Cash Receipts JournalRecord all cash received from sales, interest, rent, or other sources.

END CHAPTER 4